Sunday, August 26, 2012

The problem with the capital gains tax

Tax policy can be frustrating. A major reason that Mitt Romney pays a lower effective tax rate than many working stiffs is that most of his income comes in the form of capital gains, which is taxed at a preferential rate (the top marginal ordinary income tax rate is 35 percent, while the long term capital gains rate is 15 percent). It may therefore seem that the easy way to implement a "Buffet rule" would be to match the capital gains rate to the ordinary income tax rate.

There are three policy dilemmas here, along with a practical problem.

The first policy dilemma is that some capital gains are nominal--they don't reflect changes in purchasing power. We recognize this problem in other places in the tax code--for example, we adjust tax brackets for inflation every year. The problem could be solved using indexing--we could tax real capital gains at the ordinary income tax rate.

The second dilemma is perhaps more controversial. In a Solow-Swan world of economic growth, more savings produce a larger and newer capital stock, both of which are key to growth (Barro and Sala-i-Martin have a lucid description). If they are correct (and the consensus is that they are), then policies that encourage both savings and flexibility are good policies. To some extent we do this with our retirement tax policies: so long as savings remain in a retirement fund, their returns go untaxed, even when securities within the fund are bought and sold. With respect to capital gains policy, this implies that we should discourage the consumption of realizations of gains, but should encourage investment flexibility. In other words, if someone sells her winners in order to buy a Jaguar, she should be taxed, but if she sells winners in order to reinvest somewhere else, she should not.

The second dilemma creates a third dilemma--the investor who makes smart decisions accumulates considerable wealth, which could lead to disproportionate political power. Capital gains preferences accelerate this phenomenon. This is particularly vexing.

Now for the practical problem--the statutory capital gains rate can be considerably different from the effective rate (my approach here follows the argument in Dave Geltner and Norm Miller's Textbook, Chapter 11). Consider an investment that pays no dividends that grows in value at 10 percent per year in a world with a statutory capital gains rate of 20 percent. Suppose the investor holds that investment for ten years, and then sells it. To put some numbers on it, a $100 investment will grow to $259.37 in value. The capital gains taxes will be $159.37*.2=$31.87, so the net to the investor after capital gains taxes with be $227.50. The internal rate of return on the investment drops from 10 percent before tax to 8.6 percent after tax. Consequently, the effective tax rate is not 20 percent, but 14 percent.

If we stretch out the investment horizon to 20 years, the effective rate drops to 10.3 percent; if we reduce it to 1 year, the effective rate matches the statutory rate of 20 percent. The point is that regardless of the capital gains rate, investors have considerable discretion at determining their effective rate. So it is almost certain that a behavioral response to a higher capital gains rate would be longer periods of time between realizations, hence lowering the effective rate. When it comes to figuring out tax policy, nothing is easy.